Warren Buffett's Favourite Ratio

Published in Investing Strategy on 2 October 2009

Return on equity is a useful tool to discover hidden gems.

As has been previously observed, return on equity (ROE) is Warren Buffett's favourite ratio to consider when choosing a share.

This is because, before you make an investment in a business you need to know the initial rate of return, not just the rate at which an investment return will grow.

Calculating return on equity

This measure essentially tries to assess how productive a company is with shareholders' money -- the higher the ROE, the better. Buffett uses this measure to see how well a company is performing compared to other businesses in its sector. You can calculate the ROE by dividing the company's profits after interest and tax by the shareholders' equity or capital base.

It is best to take an average of the shareholder equity, for example using the equity at the start of the financial year and the end and dividing by two. For example, if a company produced net income of £5m, started the year with £40m in shareholders' equity and ended the year with £60m, its return on equity would be 10%:

ROE = £5m / 0.5*(£40m+£60m) = 0.1 or 10%

In this instance, the management of the company obtained a 10% return on the resources shareholders gave them.

What to look for

It should be borne in mind that if the ROE is less than the rate you can get on a gilt, you are hardly getting the return you deserve for the risk you are running in holding the share. Moreover, if a company's ROE is less than its cost of capital, management is actually destroying, rather than creating, value.

It is believed that Buffett prefers a company that has an ROE in excess of 15%. This is because a high ROE will necessarily lead to increased profits and an increase in a company's intrinsic value. (If the rate is in excess of 50% you have probably calculated incorrectly).

Since debt is subtracted from assets to calculate shareholder equity, companies using lots of debt can dramatically increase their ROE. However, you need to take a view on this as high debts have to be serviced. High returns on equity achieved with little or no debt are obviously considered more desirable.

Another important point is that you should look for a company producing a high ROE consistently over a number of years, to ensure it isn't just a cyclical phenomenon or down to some aggressive accounting. If you can buy such a company at an attractive valuation then you could have bagged yourself a long-term winner.

Some drawbacks

There are a few things that you need to beware when attempting to analyse figures in a report and accounts using this ratio.

  • See that the profit figure hasn't been artificially inflated. There are numerous ways that this can happen, perhaps a large profit on the disposal of a property.

  • See if the capital base has been reduced. This can be done by writing off goodwill. For that reason it is necessary to add into the shareholder equity denominator the cumulative goodwill that has been written off.

  • Exceptional items can also skew the picture and, even if they can't be related to a balance sheet item, they should still be added back in to the denominator. Too many companies make a habit of using exceptional costs to bury bad news and wasted shareholder resources.

Lastly, remember that while ROE is a useful tool to unearth possibly great shares, it is an historic ratio and is only a starting point before investigating further and deciding whether or not to invest in a business.

More from Chris Menon:

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